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Now, here's the good news about European banks

Two recent pieces of news have reinforced one of our strongest convictions: that rising capital ratios within European banks are here to stay, and, for the first time since Greece’s sovereign debt was downgraded to junk in 2010, the region’s banks are not at the epicentre of the market’s weakness.

It has been reported that the European Central Bank’s (ECB’s) supervisory board is setting draft capital ratios for 100 banks in the eurozone as part of its SREP – or, to provide its full title, the Supervisory Review and Evaluation Process – for 2016. These 100 banks have two weeks to respond with any comments before the ECB sets its final, and binding, requirements in the fourth quarter of the year.

As yet, we don’t know whether these banks will have to disclose their needs, as last time only Italian lenders and some institutions from Austria and Germany did so. Allegedly some 80% of the institutions supervised by the ECB will be required to hold a Common Equity Tier 1 (CET1) ratio of between 9-12%, with ‘half of the total’ required to be at 10%. This is more than was expected, with the average CET1 for a sample of European banks coming in at 11.1% (see figure 1).

Figure 1. European banks by numbers

Source: Computations by Hermes Credit based on bank disclosures, Bloomberg data as at 9 September 2015

It has also been suggested in the press that the minimum total loss absorbing capital (TLAC) requirement for the world’s systemically important banks will initially be set at 16% of their risk-weighted assets, plus buffers, from 2019 onwards. This would then rise to 20%, plus buffers, by 2022.

The crux of the matter is which liabilities will count towards the TLAC ratio. The Financial Stability Board will convene on 25 September and presumably finalise its proposal, but will likely reveal the official rules at the G20 meeting in Turkey in November.

However, taking a step back, we think both pieces of news are positive for the credit spreads of European banks. This is because the ECB and European Banking Authority, on top of their ambitious stress test next year, are keeping the optimistic dividend promises of bank CEOs very much in check.

At present, the average total capital ratio for European banks is strong at 21% (see figure 1). The institutions’ progress in strengthening balance sheets indicates that this will continue to rise. The only snag is the potential for increasing supply to put some pressure on valuations – however, given the challenges the banks have surmounted in recent years, this is a nice problem to have.